Admit economic ignorance

According to the author, it is time for economists to admit they are stumped. Policymakers and pundits still make confident predictions but the conclusions end up radically different. The author goes on to explain six different questions that professionals should stop pretending they know the answer to.

By Edward Hadas
October 31, 2012
Reuters

It is time for economists to admit that they are stumped. Four years after being blindsided by Lehman Brothers’ collapse, the profession is still stumbling in the dark. Policymakers and pundits still make confident pronouncements, but the conclusions are radically different. The expert disagreements give away the truth: ignorance reigns.

Here are six crucial questions which professionals should stop pretending they can answer:

1) What creates retail inflation?

If, as some economists think, ample supplies of money push up prices, then the current inflation rates of around 2 percent are inexplicably low. After all, monetary and fiscal policies have never been as generous. If, as other professionals believe, prices fall when there is excess supply of goods and labour, then inflation rates are inexplicably high. Production is still well below trend levels and unemployment rates have rarely been as high.

2) How do financial asset prices affect the real economy?

Before the credit bubble burst, most economists believed high prices in financial markets were a sign and a cause of a strong economy. Now bull markets seem more dangerous. But then again, low or falling asset prices seem to discourage economic activity, and they are presumably more dangerous when leverage levels are high.

3) Do big fiscal deficits damage the economy?

Austerity fans are persuaded that deficits are harmful, stimulus fans are equally certain they are not. The evidence, from Japan, Europe and the United States, is inconclusive. The largest government budget shortfalls ever in peacetime have neither clearly held back nor obviously increased either GDP growth or employment. The situation might have been much worse with smaller deficits, or the current high deficits may actually be storing up terrible trouble of some sort for later. No one really knows.

4) What does quantitative easing actually do?

Central banks’ balance sheets certainly expand when they use newly created funds to buy government debt. Other than that, nothing much is clear. The weight of the additional money may depress bond yields or the fear of inflation might eventually increase them. QE may encourage banks to increase lending, or it may not. Governments may feel less restraint on fiscal policy, or they may not.

5) How much leverage is too much?

Some amount of debt is desirable in an economy; the borrowing and corresponding savings reflect a beneficial shift of resources from those with too much to those in need. Some amount of debt is too much; when relatively small defaults can start a chain reaction of institutional failures. There does not seem to be any way to know when the boundary line between helpful and dangerous levels has been crossed.

6) How to deleverage without damaging the economy?

The debt danger line was certainly crossed sometime before the 2008 financial crisis and the subsequent euro crisis. Now policymakers are trying to reduce debt levels without harming the real economy. As yet, they have managed to do little more than shift debt from private to government balance sheets. That might prove more harmful than helpful, if the euro zone’s sovereign crises prove the first of many.

This list of economic mysteries is far from complete. The experts cannot determine whether or when capital controls are useful, how changes in foreign exchange rates effect production, what can reduce persistent high unemployment rates, or where confidence comes from. They are at a loss to explain the financial implications of the shift in the global economic balance to favour developing countries.

Economists who can answer any of these questions deserve Nobel prizes. There is a generation’s worth to be won. Unfortunately, while the prizes can wait, policy has to be made now, in confusion and ignorance.

The world has been here before, during the 1930s Great Depression. Then John Maynard Keynes provided helpful insights about the appropriate role of the government in the economy and the way that the supply of money and credit interacts with economic activity. He came late, though. If his insights had been believed after World War One, the second one might have been avoided.

Global war is not on the horizon, but the cost of ignorance about basic economic questions is still substantial: four years of disappointing growth and unacceptably high unemployment in most developed economies, without even a clear improvement in financial conditions. There are signs that the worst may be over, but the steady GDP growth that was taken for granted before the crisis remains a distant dream.

While waiting for definitive answers, economists should strive for humility. They have much to be humble about. Besides, the admission of ignorance can open the mind. Socrates, the father of Western philosophy, said that while he knew no more than his Sophist rivals, he was a “tiny bit wiser” because at least he knew that he did not know.

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